Must know: Do inflation-indexed bonds make for easier investments? (Part 2 of 4)
The relationship between TIPS and Treasuries serves as a good macro-economic indicator:
The chart above shows how the break-even inflation rate takes a dip after 2008 up to 2009. This was the time when the sub-prime crises took its toll on the world economy.
While both TIPS as well as Treasuries are popular among the investing community, it’s what you primarily want from your investment that decides which one to invest in. While TIPS effectively provide insurance against interest-rate volatility caused by inflation, other Treasuries quote higher yields. TIPS yields tend to be lower because the market will generally pay a premium, that is, accept a lower yield for the benefit of protecting the real yield from inflation.
With TIPS, you’re guaranteed your quoted yield, plus adjustments for inflation, when held till maturity. In effect, your real returns are protected. However, in case of a regular Treasury bond your real returns may be very different from the higher yield quoted, given the real yield decreases with increase in inflation. For example, if the quoted yield on a regular Treasury bond is 4%, and inflation is 3%, your real return from the bond is actually just the difference, that is, 1%.
Comparing TIPS and Treasuries with same maturity and assuming both are held till maturity, if the rate of inflation exceeds the break-even inflation rate, that is, the difference in the quoted yields of both these securities, TIPS will generate better returns for the investor. On the contrary, if the inflation rate does not exceed the break-even rate, Treasuries will do better.
So, when the break-even inflation rate for TIPS of a particular maturity is less than what you believe the inflation is likely to be in the future, TIPS could be a good choice compared to non-inflation-adjusted Treasuries. In all, which of the two is better depends on the expected inflationary and interest-rate environment.
Browse this series on Market Realist:
- Part 1 - Are inflation-indexed bonds designed to protect investors?
- Part 3 - The new wave: The US Treasury’s FRNs with a two-year maturity date
- Part 4 - Must know: Being prepared for the upcoming interest rate rise
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